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Is any expansion of the central bank’s balance sheet inflationary? And does ‘quantitative easing’ (whatever that is)* amount to ‘the last refuge of declining economic empires and banana republics’?The ‘last refuge’ phrase comes from a Sunday Telegraphcolumn by Liam Halligan on 2nd January last year, in which he attacked both ‘QE’ as a concept and my own views on inflation. I had to respond to the attack which, although polite enough, was directed at me personally. The sequel was a request from me (in two International Monetary Research weekly e-mails, of 6th January and 17th January 2011) to Halligan to quantify his views on inflation and to hold a public debate on the matters at issue. Obviously, these matters were and remain vital to investment decisions, as well as public policy. Halligan declined the invitation to a public debate. I then offered him a wager (with up to £100,000 at stake) on inflation prospects. Halligan’s article of 2nd January 2011 forecast a big rise in inflation because of QE, which began in March 2009. I said the wager should therefore be about the question, ‘will the average annual inflation rate in the two years from March 2011 be 3% or more higher than in the previous two years?’. He would win if inflation were to accelerate by more than 3% a year; I would win if inflation came in lower.

We now have inflation data for 18 months of the two-year period. The purpose of the current weekly e-mail is to see how inflation has in fact behaved. To repeat, these matters are vital to investment decisions and public policy. Halligan makes claims to have been particularly prescient about inflation. Let us check whether he has been right or wrong about QE and inflation.

* ’QE’ is ambiguous. Standard practice in the USA and Japan is to define QE as the expansion of the monetary base by central bank purchases of assets from the banks; standard practice in the UK is to define QE as the expansion of the quantity of money by central bank purchases of assets from non- banks.

Liam Halligan on QE and inflation in January 2011

Over the last four years Liam Halligan, chief economist at Prosperity Capital Management, has vented fury against ‘quantitative easing’ in his column in The Sunday Telegraph. Halligan writes well and is never dull, but eloquence should not be confused with depth of knowledge and understanding. He has over the four-year period claimed on many occasions that QE is highly inflationary and that the looming acceleration in inflation to much higher levels justifies investment in ‘hard assets’ (such as metals, both precious and base). (On its website Prosperity Capital Management is said to believe strongly ‘in the long-term investment potential of Russia’. According to Bernard Sucher, its head of Russian markets, ‘PCM has the courage of its well-informed convictions, and has reaped the benefits…’. Some of PCM’s most successful investments have been in mines and mining companies, i.e., hard asset investments.)

I criticized Halligan in my column in the January/February 2011 issue of Standpoint. The nub of his critique of QE was that it was a polite expression for ‘printing money’, which he interpreted to be inflationary almost by definition. My answer was that nowadays bank deposits, not bank notes, are the most significant form of money, and bank deposits are not ‘printed’. Deposits are instead created by an even shabbier method, namely the simultaneous addition of identical sums to both sides of a bank balance sheet, usually by a secretary typing in entries on a balance sheet on instructions from a loan officer or bank manager. New loans are banks’ assets, and new deposits are banks’ liabilities. (J. K. Galbraith, the American economist who wrote The Affluent Society, once remarked, ‘The process by which banks create new money is so simple the mind is repelled.’)

Further, inflation should be understood as arising from excessive growth of bank balance sheets (and hence of the bank deposits which constitute the bulk of the quantity of money) relative to the trend rate of increase in national output. The note issue is not by itself particularly important in modern circumstances to the key processes at work. True enough, some versions of QE do involve expansion of the so-called ‘monetary base’, which consists of bank notes and banks’ cash reserves at the central bank, while banks’ cash reserves are readily convertible into notes. But a mechanical link between the monetary base and the quantity of money is not to be expected. In any case, the relevant money aggregate in the determination of macroeconomic outcomes and inflation is a broadly-defined one, i.e., one dominated by bank deposits. In 2010 and 2011 money on the broad definitions was not growing rapidly in the UK. It therefore did not signal a big acceleration in inflation. In my view, Halligan’s argument – in short, that QE meant ‘the printing of money’ and would necessarily lead to more inflation – was wrong.

The title of Halligan’s column in his Sunday Telegraph column on 2nd January 2011 was ‘Why Congdon is on the losing side of the monetary easing argument’. Its wording was pretty fierce, although nice enough to me on a personal level. Money printing, and hence QE, were said to be ‘the last refuge of declining economic empires and banana republics’. The main inflationary mechanism in Halligan’s world was not clearly spelt out, but it seemed to pivot on the rapid growth in bank lending that he thought would follow the increase in banks’ cash reserves. To quote, ‘…the inflation has only just begun. The vast majority of the QE money in the…banking system, on both sides of the Atlantic, has yet to enter circulation. When it does, and is lent against many times over, we’ll see QE’s true inflationary impact.’

This seemed to me very implausible, not least because both then and now banks in the advanced countries – including particularly banks in the UK – were under regulatory pressure to hold more capital relative to assets and indeed to ‘deleverage’. The regulatory pressure was likely to restrict new bank lending for an extended period, implying that money growth would also remain weak. In Halligan’s eyes my own relaxed view on inflation was wrong. Since in his view the acceleration in inflation had ‘only just begun’, I asked him to define what he meant more precisely. Could he please say how much inflation would be recorded over a particular period of time? For his assertions to be anything more than wind, he needed to be exact in terms of both quantification and timing. Clearly, I would indeed be ‘on the losing side of the monetary easing argument’, if he could give a rigorous inflation forecast and his forecast proved more correct than mine. I also invited him to debate these matters with me in public, either live at a particular venue or by exchange of written statements.

At this point Halligan clammed up. He refused a live debate and did not answer the questions I asked him in my e-mails. He refused altogether to pursue the discussion. (He was also very rude to me in an e-mail he said was not for wider circulation, but these things happen.)

The wager

I wasn’t surprised by Halligan’s behaviour. No doubt Prosperity Capital Management has ‘the courage of its well-informed convictions’, but I could see that its chief economist hadn’t got the right theory of inflation. Indeed, I was pretty confident that he didn’t know what he was talking about and, even worse, that he knew that he didn’t know what he was talking about. His columns are for the most part swagger and bluster. Unfortunately (and amazingly), many people active in politics, business and finance hold what they believe are ‘well-informed convictions’ on the basis of what they read in newspapers, including The Sunday Telegraph. For all his faults, Halligan was and remains influential. To my surprise The Spectator has chimed in over the last year or two with articles that are similarly hostile to QE, from both its editor, Fraser Nelson, and such authorities as James Delingpole (described by the magazine as ‘a writer, journalist and broadcaster who is right about everything’). (Mr. Nelson at one point suggested that I might debate with Halligan in the pages of The Spectator, but nothing materialized.) QE-phobia seems to have gone viral in some sections of the British media.

So I thought I should show that I too could have convictions. I challenged Halligan to a wager. Given the stridency of his rhetoric (‘banana republics’, if you please), he must have had in mind quite a large rise in inflation. Let us not forget that – within the working lifetimes of many still active politicians, economists and journalists – UK inflation has exceeded 25%. If Halligan’s forecast of a doom-and- destruction rate of inflation meant anything, he must have been expecting in January 2011 that inflation would rise in the foreseeable future by at least 3% a year in the period where QE could be affecting the inflation rate. QE started in March 2009. I suggest that it could not, meaningfully, be relevant to inflation trends much beyond a date four years later. So my wager was as follows,

I will pay Halligan any figure he cares to mention up to £100,000 if the increase in RPIY in the two years from March 2011 is 6.1% or more higher than the increase in RPIY in the two years from March 2009. Halligan will pay me the same figure (i.e., the figure up to £100,000), if the increase in RPIY in the two year from March 2011 is 6.0% or less than the increase in RPIY in the two years from March 2009.

I would have been perfectly relaxed if Halligan had come back with a wager for a fairly modest sum of money, like ‘enough to pay for lunch at the Savoy’ or something like that. I was more or less certain I would win, but I saw the matter in contention as intellectual rather than financial.

Anyhow Halligan declined the wager.

So what has happened to inflation since January 2011?

We now have the numbers for UK consumer and retail inflation for 18 months of the 24 months to which my proposed wager related. Has inflation taken off in the way that Halligan’s columns predicted? (If he says that he didn’t predict any rise in inflation, I must refer him to the words of his 2nd January 2011 column. If he says that those words were, well, just words with no exact meaning [i.e., wind], my reply is ‘you bet’. Top journalists – even famous international pundits – are allowed to let off steam with shoddy polemics, as long as they don’t pretend to be involved in some more serious activity.)

Above we have a chart for RPIY inflation since the official series for this inflation measure began. QE was introduced in March 2009 because of a slump in economic activity and fears of future deflation, even though at the time inflation was running at well above the official target. As the chart shows, inflation tumbled in the rest of 2009 and into early 2010, to some degree justifying the strong measures taken by officialdom (meaning QE, above all) to check the slump. By spring 2010 many observers felt that the UK economy, in a reviving world economy, could look forward to a reasonable recovery. In practice the world economy enjoyed a spectacular rebound in 2010, but the leaders were such nations as China and India with their voracious demand for raw materials and energy. It was the resulting surge in commodity prices that lay behind the return to rising inflation in 2011.

Halligan’s column in January 2011 coincided with a widespread recognition in the UK forecasting community that a second inflation peak was in prospect because of commodity price developments. But the surge in commodity prices was an adverse international influence on the UK price level last year; it applied to all countries, including those – for example, in the Eurozone – where no meaningful QE operations were implemented; it did not reflect any upturn in domestically generated inflation pressures, such as might reasonably be attributed to the UK’s own macroeconomic policies. (Having said that, I agree that excessive money growth can lead to a fall in the exchange rate, which then means that the domestic prices of all imported goods – and not just imported commodities – have to increase. But the pound has not been weak on the foreign exchanges in the period since the announcement of QE in early 2009. The pound was very weak in the year to January 2009, but the cause must be sought earlier, before QE came in, perhaps – I suggest – in the rapid broad money expansion of the three years to mid-2007. The relationship between money and inflation is bedevilled by unpredictable lags.)

At any rate, it is evident from the chart that inflation since March 2009 (i.e., since QE) has not been dramatically different from inflation in the previous few years. It has on average been a touch higher, but rhetoric about banana republics has plainly been unjustified. In 2012 the impact of the 2010 commodity price surge on UK inflation, which was so bad in 2011, had fallen out of the indices. Consumer price inflation has certainly been above target for much of the last few years, but it is not at present outside the permitted ‘1% either side of the 2% target’ band. Let us notice at this point that we are now almost four years from the most vicious phase of the Great Recession (i.e., in late 2008 and early 2009), when QE first became prominent in the public debate. Let it also be emphasized that the increase in RPIY in the year to September 2012 was only 2.1%, much less than in early 2009 when the QE programme was being discussed and designed. We may now move, more specifically, to see whether – if Halligan had accepted the terms of my wager – he or I would have been wrong. Sure, we still have six months to go before we have the March 2013 inflation figures and so the result will not be absolutely final. However, as we shall see, the outcome is pretty definite.

The result of the wager

The wager was proposed in January 2011. To repeat, it was about whether inflation would be much higher (i.e., by more than 3% a year) in the two years then in prospect than in the previous two years, with the bet to start in March 2011. The inflationary potential of QE was the issue at stake, with March 2011 being the second anniversary of QE and March 2013 the fourth anniversary. (And, to remind, the RPIY index was chosen, because it would not be affected by changes in interest rates and indirect taxes. It would – in other words – be a relatively clean measure of ‘underlying inflation pressures’.)

According to the terms of the wager, Halligan’s forecasts of a sharp QE-fuelled intensification of inflation would be correct if the RPIY index were to take a value of 128.5 or more in March 2013. As the box above shows, the increase in RPIY in the 18 months to September 2013 was 4.5%, i.e., at an annualised rate of 3.0%. Inflation did therefore proceed at a somewhat faster rate than in the preceding two years, when the average annual rate was just above 2.1%. The mild acceleration in inflation is not a surprise compared with expectations in early 2011, because practically all forecasters envisaged quite a lot of damage from the follow-through from the 2010 commodity price rises. However, inflation was not markedly different in the 18 months to September 2012 than in the previous two years and, expressed at an annual rate, it was certainly not 3% or more higher.

Indeed, given the numbers so far in the two-year period in contention, it is virtually inconceivable that Halligan could have won the wager if he had accepted it. The box demonstrates that – for inflation to be more than 3% higher in the two years to the fourth anniversary of QE than in the previous two years – the annualized rate of increase in the six months to March 2013 would have to be almost 12%. There is no sign of that whatsoever.

If Halligan had taken up my wager with him at the start of last year and entered into its full spirit (i.e., agreed that the wager should be for £100,000), he would now have to be thinking about how to pay me that sum of money.

The more serious matters at stake

Anyone who has read this far may say that this is all rather petty. A typical observation to me has been that Halligan is not a serious commentator and so he doesn’t deserve to be taken seriously. Why bother to prove the point when there are more important things to do? I understand and of course agree that Halligan doesn’t deserve to be taken seriously. However, I would like to offer three comments by way of conclusion.

First, The Sunday Telegraph gave me no opportunity to reply to an ad hominem criticism of a position I had taken. The Halligan article on 2nd January 2011 was not a set of general remarks on the inflation outlook, but a direct attack on a view I had expressed. In a newspaper headline I was said to be ‘on the losing side’ of a prominent public debate. I had to do something. (Halligan must have known that that I had been spectacularly right in earlier medium-term inflation forecasts, notably those I made in the Lawson boom of the late 1980s, and that may have been why he made the attack so personal.)

Secondly, The Sunday Telegraph has widespread influence, particularly on the right of British politics. It ought not to have come as a surprise that The Spectator should chime in with a similar view to Halligan’s. The result has been a wider misrepresentation of QE in the media, which is now reaching absurd levels. QE is a branch of monetary policy, and its analysis ought to be mostly at a technical, non-political level.

Thirdly, the underlying issue here is ‘what is the correct concept of money, the appropriate “money aggregate”, in the monetary theory of national income determination and, hence, in prognostications about inflation?’. The answer – as I have insisted in a large body of work – is a broadly-defined measure (such as M4 in the UK, or M3 in any of the USA, the Eurozone or Japan). It was my focus on broad money which helped me to be right about the inflationary consequences of the Lawson boom of the late 1980s. It also led me in early 2007 to forecast – in evidence to two parliamentary enquiries – that the UK would see a sharp rise in inflation over the next few years. It is also the background to my rejection of the inflation hysteria of columnists like Halligan who – insofar as they have a meaningful theory – think in terms of the monetary base (i.e., for the most part of the note issue, which is ‘printed’).

Will Halligan apologize for criticising me in such personal terms in January 2011? Well, I don’t expect him to, just as I didn’t expect him to take up the wager that would have settled the debate. What was that someone said about ‘well-informed convictions’?